Monday, August 17, 2009

Capital Controls, Financial Regulation and the Global Economic Crisis of 2008–2009

In 2008–2009, the world has seen the worst financial crisis since the Great Depression.

In 2002–2004, large amounts of money flowed into the US from East Asia and oil-producing countries at a time when the US Federal Reserve had an easy money policy of low interest rates.

The blogger Cynicus Economicus has argued that
This massive wall of money invested into consumer borrowing created a fundamental problem. In simple terms, the first tranche of money invested ought to find the cream of the investment opportunities. However, as more money enters the system, good opportunities become scarcer – but it must still ‘go’ somewhere. In such circumstances, the capital is allocated to ever riskier investments, which explains the rise in popularity of collateralised debt obligations (CDOs) and other, similar financial instruments. These practices were simply a method of burying bad investments, while creating an illusion of continued low risk … In such a situation, we can see the roots of the house-price boom in the US, UK, Spain and Ireland (among other places) – a classic asset-price bubble in which there was a massive increase in the supply of money and the money simply chased an asset-base that could not expand as fast as the supply of money. A boom in land and property prices was inevitable …
Thus Cynicus Economicus contends that the flood of money from the East to the West with insufficient investment opportunities to “soak up” the money was the underlying and real cause of the crisis. Furthermore, it is claimed that nobody can show how “any regime might have coped with the influx of money from the East” since the “the money coming from the East created a circumstance that was entirely novel in the West.” Thus “the money would have arrived in the economy, and bubbles would [have appeared].” (see note 1 below).

This thesis, I believe, is false. The situation was not novel, and there were clearly ways in which the West could have prevented the asset bubbles.

Was There No Way to Prevent Asset Bubbles in the West?
First, it is simply not true that the flood of money flowing into the West from 2000 to 2006 was unprecedented or novel. There is an obvious historical parallel: the petrodollars that started flooding into London and New York banks in 1973–1974 and 1979 after the “oil shock” price surge. In 1974, the Arab oil-producing countries had a current account surplus of $68 billion US, which they mostly invested in the West (in 2007 inflation-adjusted US dollars that would be the equivalent of $285 billion entering the US economy). In 1975, these countries had a surplus of US $92 billion, an even greater amount.

And yet the Western financial system was not destroyed by large destructive asset bubbles in these years. Why?

The reason is that we had effective financial regulation that still existed before the onslaught of deregulation in the 1980s and 1990s.

Secondly, controls on capital inflows were actually a regular part of capital controls in the Bretton Woods era and in some countries well into the 1980s (Goodman and Pauly 1993: 282).

The dangers of large destabilizing capital inflows into an economy are well known. They can result in:
(1) damaging appreciation of a nation’s exchange rate that harms its exports and trade;

(2) short-term capital or “hot money” that causes financial instability and rapid outflows due to irrational herd behaviour and in turn balance of payments crises, and

(3) asset price bubbles, if there are very large inflows (Magud and Reinhart 2007: 647).
There are effective ways to prevent all these things. For instance, in Europe, which experienced large petrodollar inflows in the 1970s,
“capital controls and domestic bank regulations … separated Eurocurrency markets from the corresponding national markets … [For instance, there were] controls on capital inflows designed to keep a strong currency from becoming stronger … [in the 1970s] the German authorities attempted to discourage capital inflows through a variety of means, including a 60% marginal reserve requirement on bank liabilities to foreigners and a 50% cash deposit ratio on foreign borrowing (Herring and Litan 1995: 33–34).
International financial centres at Paris and Frankfort remained heavily regulated until the 1980s (Jones 1996: 188). As late as the 1970s, both Switzerland and Germany imposed controls on capital inflows to prevent currency appreciation and too rapid an expansion of their domestic money supplies from foreign inflows (Quirk 1995: 9). Germany, in particular, did so during 1971–1975 and from 1977–1981, precisely the time when petrodollars were flooding into Europe through Eurodollar markets. It is no surprise that, despite the massive flood of money in the 1970s, there were no destructive asset bubbles in the West.

Charles Kindleberger in the classic Manias, Panics, and Crashes: A History of Financial Crises (5th edn, John Wiley and Sons, 2005) shows that financial crises are a perennial characteristic of unregulated financial systems: from 1725 to 1929 destructive bubbles have occurred roughly every eight and half years in the West. But they largely disappeared in the Bretton Woods era (1945–1973).

Capital account liberalization and deregulation of financial markets started in the 1970s and intensified in the 1980s and 1990s. The results have been predictable: a massive rise in financial crises and destructive asset price inflation.

Quite simply, an important real cause of the crisis and the asset bubbles was capital account and financial liberalization. It is utterly false to say that real estate and stock market bubbles are inevitable.

Note 1
The views of Cynicus Economicus are presented in these articles:
“Five minutes to midnight,” Trade and Forfaiting Review 12.5 (23 March, 2009)

“Underlying Economic Crisis Caused Financial Crisis,”

Calvo, G. A., Leiderman, L. and C. M. Reinhart, 1994, “The Capital Inflows Problem: Concepts and Issues,” Contemporary Economic Policy 12 (1994), 54–66.

Goodman, J. and L. Pauly, 1993, “The Obsolescence of Capital Controls? Economic Management in an Age of Global Markets,” in J. A. Frieden and D. A. Lake, International Political Economy: Perspectives on Global Power and Wealth, St. Martin's Press, New York, 1991. 280–298.

Herring R. J. and R. E. Litan, 1995, Financial Regulation in the Global Economy, Brookings Institution, Washington, D.C.

Jones, G., 1996, The Evolution of International Business: An Introduction, Routledge, London and New York.

Magud, N. and C. M. Reinhart, 2007, “Capital Controls: An Evaluation,” in S. Edwards (ed.), 2007, Capital Controls and Capital Flows in Emerging Economies: Policies, Practices, and Consequences, University of Chicago Press, Chicago and London. 645–674.

Quirk, P. J., Evans, O., Gajdeczka, P. et al., 1995, Capital Account Convertibility: Review of Experience and Implications for IMF Policies, International Monetary Fund, Washington, DC.

Rajan, R. S., and I. Noy, 2008, “Capital Controls” in K. A. Reinert, R. S. Rajan et al. (eds), The Princeton Encyclopedia of the World Economy, Princeton University Press, Princeton, 2009. 152–156.

Appendix 1: Capital Controls in the West

You can see here when capital controls were abolished in most Western countries. It is clear that throughout the 1970s Western countries were protected from damaging capital inflows.

UK – 1979, capital controls abolished.

Japan – 1980, capital controls abolished.

Germany – 1958, abolition of control on capital outflows; severe restrictions on inflows until 1969, then again from 1971–1975 and 1977–1981; final abolition of remaining controls in 1981.

Australia – 1983.

New Zealand – 1984.

Netherlands – 1986.

France – 1989, remaining controls abolished.


  1. I appreciate everything you have set out and moreover there are some few thing I would like to add.
    First of all, it is false to deal with only two parties. There is no economic unity in the west as well as there is no in the east. Second, the subprime crisis causes the financial crisis and so it hits some countries of Europe immense, because they (not east-asian countries) have invest in the US Real Estate market as well as in risky deals of the financial market. Especially countries whose financial market is almost completely regulated by private banks struggled.
    Third and more important, such crisis are common and normal for an highly unregulated financial system because it is build on bubbles because of its risky and allowed financial transactions which have only a fictional value instead of real goods. But one thing we could learn of the crisis:

    The thesis that a bank could be too big to fail is false. And if the governments had not invest a lot of money into the financial market even more banks would have crashed.